------- Forwarded Message Date: Thu, 16 Oct 1997 11:40:46 -0500 (CDT) To: believer@telepath.com From: believer@telepath.com Subject: IP: End of National Markets Forwarded: - -----------
From the USIA Daily Washington File http://www.usia.gov/products/washfile.htm
15 October 1997
THE END OF NATIONAL MARKETS (Electronic cash makes regulation difficult)
by Stephen J. Kobrin
(Copyright (c) 1997 Carnegie Endowment for International Peace. Reprinted with permission from FOREIGN POLICY magazine, Summer 1997. Permission has been obtained covering republication/translation/abridgment by USIS and the local press outside the United States.)
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Twenty-six years ago, Raymond Vernon's "Sovereignty at Bay" proclaimed that "concepts such as national sovereignty and national economic strength appear curiously drained of meaning."
Other books followed, arguing that sovereignty, the nation-state, and the national economy were finished -- victims of multinational enterprises and the internationalization of production. While sovereign states and national markets have outlasted the chorus of Cassandras, this time the sky really may be falling. The emergence of electronic cash and a digitally networked global economy pose direct threats to the very basis of the territorial state.
Let us begin with two vignettes. Fact: Smugglers fly Boeing 747s loaded with illicit drugs into Mexico and then cram the jumbo jets full of cash -- American bills -- for the return trip. Fiction: Uncle Enzo, Mafia CEO, pays for intelligence in the digital future of Neal Stephenson's novel Snow Crash: "He reaches into his pocket and pulls out a hypercard and hands it toward Hiro. It says 'Twenty-Five Million Hong Kong Dollars.' Hiro reaches out and takes the card. Somewhere on earth, two computers swap bursts of electronic noise and the money gets transferred from the Mafia's account to Hiro's."
The 747s leaving Mexico are anachronisms, among the last surviving examples of the physical transfer of large amounts of currency across national borders. Most money has been electronic for some time. Virtually all of the trillions of dollars, marks, and yen that make their way around the world each day take the form of bytes -- chains of zeros and ones. Only at the very end of its journey is money transformed into something tangible: credit cards, checks, cash, or coins.
Hypercards are here. Mondex, a smart card or electronic purse, can be "loaded" with electronic money from an automatic teller machine (atm) or by telephone or personal computer using a card-reading device. Money is spent either by swiping the card through a retailer's terminal or over the Internet by using the card reader and a personal computer. An electronic wallet allows anonymous card-to-card transfers.
It is not just the current technology of electronic cash (e-cash) or even what might be technologically feasible in the future that presents policymakers with new challenges. Rather, policymakers must confront directly the implications of this technology -- and, more generally, the emergence of an electronically networked global economy -- for economic and political governance. As the U.S. comptroller of the currency, Eugene Ludwig, has noted, "There is clearly a freight train coming down the tracks...Just because it hasn't arrived yet doesn't mean we shouldn't start getting ready."
ELECTRONIC MONEY
Many different forms of "electronic money" are under development, but it is useful to look at three general categories: electronic debit and credit systems; various forms of smart cards; and true digital money, which has many of the properties of cash.
Electronic debit and credit systems already exist. When a consumer uses an ATM card to pay for merchandise, funds are transferred from his or her account to the merchant's. Credit cards are used to make payments over the Internet. Computer software such as Intuit provides electronic bill payment, and it is but a short step to true electronic checks --authenticated by a digital signature -- that can be transmitted to the payee, endorsed, and deposited over the Internet.
Electronic debit and credit systems represent new, more convenient means of payment, but not new payment systems. A traditional bank or credit card transaction lies at the end of every transaction chain. Smart cards and digital money represent new payment systems with potentially revolutionary implications. Smart cards are plastic "credit" cards with an embedded microchip. Many are now used as telephone or transit payment devices. They can be loaded with currency from an atm or via a card reader from a telephone or personal computer, which can then be spent at businesses, vending machines, or turnstiles that have been equipped with appropriate devices. At this most basic level, a smart card is simply a debit card that does not require bank approval for each transaction; clearance takes place each day and the value resides in third-party accounts. There is no reason, however, that smart cards have to be limited in this way.
Banks or other institutions could provide value on smart cards through loans, payments for services, or products. The immediate transfer of funds between bank accounts is not necessary; units of value can circulate from card to card -- and from user to user -- without debiting or crediting third-party accounts. Assuming confidence in the creating institution, "money" could be created on smart cards and could circulate almost indefinitely before redemption.
Finally, electronic money can take true digital form, existing as units of value in the form of bytes stored in the memory of personal computers that may or may not be backed up by reserve accounts of real money. The money could be downloaded from an account, supplied as a loan or as payment, or bought with a credit card over the Internet. As long as digital cash can be authenticated and there is confidence in its continued acceptance, it could circulate indefinitely, allowing peer-to-peer payments at will. These are big "ifs," but they are well within the realm of the possible.
Imagine a world where true e-cash is an everyday reality. Whether all of the following assumptions are correct or even immediately feasible is unimportant; some form of e-cash is coming, and we need to begin the process of thinking about its as-yet-unexplored consequences for economic and political governance.
The year is 2005. You have a number of brands of e-cash on your computer's hard drive: some withdrawn from a bank in Antigua, some borrowed from Microsoft, and some earned as payment for your services. You use the digital value units (DVUs) to purchase information from a Web site, pay bills, or send money to your daughter in graduate school. Peer-to-peer payments are easy: You can transfer DVUs to any computer anyplace in the world with a few keystrokes.
Your e-cash is secure and can be authenticated easily. It is also anonymous; governments have not been able to mandate a technology that leaves a clear audit trail. Public-key encryption technology and digital signatures allow blind transactions; the receiving computer knows that the DVUs are authentic without knowing the identity of the payer. Your e-cash can be exchanged any number of times without leaving a trace of where it has been. It is virtually impossible to alter the value of your e-cash at either end of the transaction (by adding a few more zeros to it, for example).
DVUs are almost infinitely divisible. Given the virtually negligible transaction cost, it is efficient for you to pay a dollar or two to see a financial report over the Internet or for your teenager to rent a popular song for the few minutes during which it is in vogue. Microtransactions have become the norm. E-cash is issued -- actually created -- by a large number of institutions, bank and nonbank. Electronic currencies (e-currencies) have begun to exist on their own; many are no longer backed by hard currency and have developed value separately from currencies issued by central banks. DVUs circulate for long periods of time without being redeemed or deposited. Consumer confidence in the issuer is crucial; as with electronic commerce (e-commerce) in general, brand names have become critical.
The early 21st century is described as a world of competing e-currencies, a throwback to the 19th-century world of private currencies. The better known brands of e-cash are highly liquid and universally accepted. It is a relatively simple matter for you to set up filters in your electronic purse to screen out e-currencies that you do not want to accept.
GOVERNANCE IN THE DIGITAL WORLD
E-cash and the increasing importance of digital markets pose problems for central government control over the economy and the behavior of economic actors; they also render borders around national markets and nation-states increasingly permeable -- or, perhaps, increasingly irrelevant. In a world where true e-cash is an everyday reality, the basic role of government in a liberal market economy and the relevance of borders and geography will be drastically redefined.
While at first glance this concern appears to reflect a traditional break between domestic and international economic issues, in fact the advent of e-cash raises serious questions about the very idea of "domestic" and "international" as meaningful and distinct concepts. The new digital world presents a number of governance issues, described below.
-- Can central banks control the rate of growth and the size of the money supply? Private e-currencies will make it difficult for central bankers to control -- or even measure or define -- monetary aggregates. Several forms of money, issued by banks and nonbanks, will circulate. Many of these monies may be beyond the regulatory reach of the state. At the extreme, if, as some libertarians imagine, private currencies dominate, currencies issued by central banks may no longer matter.
-- Will there still be official foreign exchange transactions? E-cash will markedly lower existing barriers to the transfer of funds across borders. Transactions that have been restricted to money-center banks will be available to anyone with a computer. Peer-to-peer transfers of DVUs across national borders do not amount to "official" foreign exchange transactions. If you have $200 worth of DVUs on your computer and buy a program from a German vendor, you will probably have to agree on a mark-to-dollar price. However, transferring the DVUs to Germany is not an "official" foreign exchange transaction; the DVUs are simply revalued as marks. In fact, national currencies may lose meaning with the development of DVUs that have a universally accepted denomination. Without severe restrictions on individual privacy -- which are not out of the question -- governments will be hard-pressed to track, account for, and control the flows of money across borders.
-- Who will regulate or control financial institutions? The U.S. Treasury is not sure whether existing regulations, which apply to both banks and institutions that act like banks (i.e., take deposits), would apply to all who issue (and create) e-cash. If nonfinancial institutions do not accept the extensive regulatory controls that banks take as the norm, can reserve or reporting requirements be enforced? What about consumer protection in the event of the insolvency of an issuer of e-cash, a system breakdown, or the loss of a smart card?
-- Will national income data still be meaningful? It will be almost impossible to track transactions when e-cash becomes a widely used means of payment, online deals across borders become much easier, and many of the intermediaries that now serve as checkpoints for recording transactions are eliminated by direct, peer-to-peer payments. The widespread use of e-cash will render national economic data much less meaningful. Indeed, the advent of both e-cash and e-commerce raises fundamental questions about the national market as the basic unit of account in the international economic system.
-- How will taxes be collected? Tax evasion will be a serious problem in an economy where e-cash transactions are the norm. It will be easy to transfer large sums of money across borders, and tax havens will be much easier to reach. Encrypted anonymous transactions will make audits increasingly problematic. Additionally, tax reporting and compliance relies on institutions and intermediaries. With e-cash and direct payments, all sorts of sales taxes, value-added taxes, and income taxes will be increasingly difficult to collect. More fundamentally, the question of jurisdiction -- who gets to tax what -- will become increasingly problematic. Say you are in Philadelphia and you decide to download music from a computer located outside Dublin that is run by a firm in Frankfurt. You pay with e-cash deposited in a Cayman Islands account. In which jurisdiction does the transaction take place?
-- Will e-cash and e-commerce widen the gap between the haves and the have-nots? Participation in the global electronic economy requires infrastructure and access to a computer. Will e-cash and e-commerce further marginalize poorer population groups and even entire poor countries? This widened gap between the haves and the have-nots -- those with and without access to computers -- could become increasingly difficult to bridge.
-- Will the loss of seigniorage be important as governments fight to balance budgets? Seigniorage originally referred to the revenue or profit generated due to the difference between the cost of making a coin and its face value; it also refers to the reduction in government interest payments when money circulates. The U.S. Treasury estimates that traditional seigniorage amounted to $773 million in 1994 and that the reduction in interest payments due to holdings of currency rather than debt could be as much as $3.5 billion per year. The Bank for International Settlements reports that the loss of seigniorage for its 11 member states will be more than $17 billion if smart cards eliminate all bank notes under $25.
-- Will fraud and criminal activity increase in an e-cash economy? At the extreme -- and the issue of privacy versus the needs of law enforcement is unresolved -- transfers of large sums of cash across borders would be untraceable. There would be no audit trail. Digital counterfeiters could work from anywhere in the world and spend currency in any and all places. New financial crimes and forms of fraud could arise that would be hard to detect, and it would be extremely difficult to locate the perpetrators. The task of financing illegal and criminal activity would be easier by orders of magnitude. E-cash will lower the barriers to entry and reduce the risks of criminal activity.
Most of the issues raised in the recent National Research Council report on cryptography's role in the information society apply directly to electronic cash. Secure, easily authenticated, and anonymous e-cash requires strong encryption technology. Anonymous transactions, however, cannot be restricted to law-abiding citizens. Encryption makes it as difficult for enforcement authorities to track criminal activity as it does for criminals to penetrate legitimate transmissions. Should privacy be complete? Or should law enforcement authorities and national security agencies be provided access to e-cash transactions through escrowed encryption, for example? What about U.S. restrictions on the export of strong encryption technology? E-cash is global cash; how can governments limit its geographic spread? Can they even suggest that strong encryption algorithms be restricted territorially?
GEOGRAPHIC SPACE VERSUS CYBERSPACE
A recent U.S. Treasury paper dealing with the tax implications of electronic commerce argues that new communications technologies have "effectively eliminated national borders on the information highway." It is clear from the paper's subsequent discussion, however, that the more fundamental problem is that electronic commerce may "dissolve the link between an income-producing activity and a specific location." The source of taxable income, which plays a major role in determining liability, is defined geographically in terms of where the economic activity that produces the income is located. Therein lies the rub: "Electronic commerce doesn't seem to occur in any physical location but instead takes place in the nebulous world of 'cyberspace.'" In a digital economy it will be difficult, or even impossible, to link income streams with specific geographic locations.
Digitalization is cutting money and finance loose from its geographic moorings. The framework of regulation that governs financial institutions assumes that customers and institutions are linked by geography -- that spatial proximity matters. E-cash and e-commerce snap that link. What remains are systems of economic and political governance that are rooted in geography and are trying nonetheless to deal with e-cash and markets that exist in cyberspace. The obvious disconnect here will only worsen over time.
The geographical rooting of political and economic authority is relatively recent. Territorial sovereignty, borders, and a clear distinction between domestic and international spheres are modern concepts associated with the rise of the nation-state. Territorial sovereignty implies a world divided into clearly demarcated and mutually exclusive geographic jurisdictions. It implies a world where economic and political control arise from control over territory. The international financial system -- which consists of hundreds of thousands of computer screens around the globe -- is the first international electronic marketplace. It will not be the last. E-cash is one manifestation of a global economy that is constructed in cyberspace rather than geographic space. The fundamental problems that e-cash poses for governance result from this disconnect between electronic markets and political geography.
The very idea of controlling the money supply, for example, assumes that geography provides a relevant means of defining the scope of the market. It assumes that economic borders are effective, that the flow of money across them can be monitored and controlled, and that the volume of money within a fixed geographic area is important. All of those assumptions are increasingly questionable in a digital world economy.
Many of our basic tax principles assume that transactions and income streams can be located precisely within a given national market. That assumption is problematic when e-cash is spent on a computer network. It is problematic when many important economic transactions cannot be located, or may not even take place, in geographic space.
The increasing irrelevance of geographic jurisdiction in a digital world economy markedly increases the risks of fraud, money-laundering, and other financial crimes. Asking where the fraud or money-laundering took place means asking "Whose jurisdiction applies?" and "Whose law applies?" We need to learn to deal with crimes that cannot be located in geographic space, where existing concepts of national jurisdiction are increasingly irrelevant.
The term "disintermediation" was first used to describe the replacement of banks as financial intermediaries by direct lending in money markets when interest rates rose. It is often used in the world of e-commerce to describe the elimination of intermediaries by direct seller-to-buyer transactions over the Internet. Many observers argue that e-cash is likely to disintermediate banks. Of more fundamental importance is the possibility that e-cash and e-commerce will disintermediate the territorial state.
To be clear, I argue that we face not the end of the state, but rather the diminished efficacy of political and economic governance that is rooted in geographic sovereignty and in mutually exclusive territorial jurisdiction. Questions such as: "Where did the transaction take place?" "Where did the income stream arise?" " Where is the financial institution located?" and "Whose law applies?" will lose meaning. E-cash and e-commerce are symptoms, albeit important ones, of an increasing asymmetry between economics and politics, between an electronically integrated world economy and territorial nation-states, and between cyberspace and geographic space. How this asymmetry will be resolved and how economic and political relations will be reconstructed are two of the critical questions of our time.
WHAT IS TO BE DONE?
The question asked here is not "What is feasible?" but "What are the limits of the possible?" Whether the picture presented here is correct in all -- or even some -- of its details is unimportant. A digital world economy is emerging. Imagining possible scenarios is necessary if we are to come to grips with the consequences of this revolution. The purpose here is to raise problems rather than to solve them and to imagine possible futures and think about their implications for economic and political governance. A digital world economy will demand increasing international cooperation, harmonizing national regulations and legislation, and strengthening the authority of international institutions.
The harmonization of national regulations will help to prevent institutions, such as those issuing e-cash, from slipping between national jurisdictions or shopping for the nation with the least onerous regulations. However, it will not address the basic problem of the disconnect between geographic jurisdiction and an electronically integrated global economy.
If it is impossible to locate transactions geographically -- if the flows of e-cash are outside of the jurisdictional reach of every country -- then the harmonization of national regulations will accomplish little. The basic problem is not one of overlapping or conflicting jurisdictions; it stems from the lack of meaning of the very concept of "jurisdiction" in a digitalized global economy. The erosion of the viability of territorial jurisdiction calls for strengthened international institutions. It calls for giving international institutions real authority to measure, to control, and, perhaps, to tax. The Basle Committee on Banking Supervision -- an international body of bank regulators who set global standards -- could perhaps be given the authority to collect information from financial institutions wherever they are located and formulate and enforce regulations globally. Interpol, or its equivalent, may have to be given jurisdiction over financial crimes, regardless of where they are committed. That does not mean a world government; it does mean a markedly increased level of international cooperation.
The questions we must face are whether territorial sovereignty will continue to be viable as the primary basis for economic and political governance as we enter the 21st century, and what the implications will be for the American economy -- and Americans in general -- if we refuse to cooperate internationally in the face of an increasingly integrated global economy.
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ELECTRONIC CASH: A GLOSSARY
DIGITAL DATA: Information coded into a series of zeros and ones that can be transmitted and processed electronically.
DIGITAL SIGNATURE: A code that allows absolute authentication of the origin and integrity of a document, check, or electronic cash that has been sent over a computer network. A blind signature allows authentication without revealing the identity of the sender.
DISINTERMEDIATION: The substitution of direct transactions for those that are mediated. The term originated when rising interest rates caused savings to be withdrawn from banks -- whose interest rates were capped -- and invested in money market instruments that were the direct debts of borrowers. Banks were disintermediated. In electronic commerce, the term refers to the rise of direct buyer-to-seller relationships over the Internet, disintermediating wholesalers and retail outlets.
ELECTRONIC MONEY: Units or tokens of monetary value that take digital form and are transmitted over electronic networks. Digital Value Units are the basic units of denomination of electronic money; they may or may not correspond to units of national currency.
ENCRYPTION: The coding of information for security purposes, such as credit card numbers or electronic cash used over the Internet. Public-key encryption uses a mathematical algorithm comprising a pair of strings of numbers to encrypt and decrypt the data. For example, the sender would encrypt the data with the receiver's public key and the receiver would decrypt with his or her private key.
INTERNET: A global network of linked networks that allows communication and the sharing of information among many different types of computers. The World Wide Web is a graphical system on the Internet that allows rapid movement between documents and computers through the use of embedded (hypertext) links.
SMART CARDS: A plastic card, similar to a credit card, containing a microchip that can be used to retrieve, store, process, and transmit digital data like electronic cash or medical information. -----------------------
(Stephen J. Kobrin is the director of the Lauder Institute of Management and International Studies and the William Wurster professor of multinational management at the Wharton School of the University of Pennsylvania. This paper develops themes raised at a discussion of electronic money at the 1997 annual meeting of the World Economic Forum in Davos, Switzerland.)
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